Striking a Balance on the Build-Out

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Thanks to a resurgence in mergers and acquisitions, 2005 was a very good year for Lane, Berry & Co. So good, in fact, that the small, scrappy investment-banking firm now faces one of the biggest challenges since its founding four years ago. Lane, Berry is racing to expand by adding 30,000 square feet of office space in New York and Denver while also moving to new, larger offices in Boston. Charting a path through these complex real-estate negotiations has fallen squarely on the shoulders of the firm’s CFO, Karen Vernamonti.

Among other things, Vernamonti has had to untangle a knot of issues that included not only the cost of rent but also the cost of outfitting the new space to suit the firm’s image-conscious bankers. Eager to move in quickly, she opted to pay a slightly higher rent on the space in return for an agreement by the landlord to build out the new offices to suit the needs of the firm. “Our build-out allowance is very important to us because it is, effectively, an interest-free loan from the landlord,” Vernamonti says. “We fought very hard for these dollars because, as a small, growing company, we want to preserve our cash flow.”

Build-out allowances cover the cost of such things as design, new carpeting, interior walls, lighting, mechanical systems, and other improvements the tenant needs to conduct business.

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Negotiating the build-out of office space is a matter of increasing importance these days. After years of stagnation, rents are beginning to rise in many cities across the United States. Vacancy rates are shrinking, most notably in New York; Washington, D.C.; and San Francisco. That means office space — already one of the top three fixed costs for many businesses — is likely to get even pricier this year.

Funding a build-out raises important tax and cash-flow considerations that could have serious long-term implications for tenants. “CFOs are getting much more sophisticated about these issues,” says James A. Schwartz, senior vice president of Equis Corp., a real-estate services firm based in Chicago. “They have to be nowadays because there are significant dollars involved in corporate real estate.”

Renting office space is an increasingly complicated transaction. A lease contract may be several hundred pages of dense legalese covering every conceivable contingency, from subleasing to repairs to such minute details as the brand of light switch used in a conference room.

“Of more than a dozen nonrent variables,” says Marisa Manley, president of Commercial Tenant Real Estate Representation Ltd. in New York, which represents clients in negotiations with landlords, “the build-out is one of the most critical. New tenants are going to be spending a lot of money in a short period of time, typically 12 or so weeks, and so the decisions they make about funding that build-out should be made with great care.”

Unfortunately, Manley adds, “CFOs’ eyes glaze over when they review these contracts.” Some are under extraordinary pressure to cut a deal quickly because the firm wants to take advantage of growth opportunities. So leases — and, ultimately, the cost of real estate — sometimes don’t get the attention to detail they require, she says. Manley urges caution for all of her clients. “Real estate is not a level playing field,” she says. “Landlords are experts in the details; tenants typically are not.”

Landlords generally fund some or all of the build-out either by paying for the work directly or by making a cash payment to the tenant after the work has been completed. Although rents and build-out allowances vary widely from market to market, the average rent per square foot in an upscale suburban office park in the Midwest or the Southwest may run about $23 to $25; the build-out allowances per square foot for the space will be about $15.

Trophy Tenants

In hot markets, though, rents and allowances are likely to be considerably higher. In Washington, D.C., which has one of the lowest office vacancy rates in the country, rents range from $35 per square foot for older buildings to $65 per square foot for brand-new digs. Landlords there have been offering build-out allowances of $40 per square foot to $75 per square foot. Still, for tenants with specialized needs, such as biotech firms that require special systems for lab work or law firms that demand high-end finishes, even a generous build-out allowance may not cover all the costs of preparing the space.

In some softer markets, landlords may offer tenants a period of rent-free occupancy or reduced rent in exchange for the tenant footing the build-out bill. However, many landlords are reluctant to lower rents on office space, because that may diminish the value of their building.

Trophy tenants — Fortune 500 companies that add prestige to the building and help attract other tenants — will likely get larger build-out allowances, as will reliable tenants with good credit ratings that take longer-term leases. In fact, “all the rules get thrown out when a big, important company comes to town to open a large office,” says Russ Howell, senior vice president of strategic services in the Integrated Real Estate & Facilities Management Solutions unit of Johnson Controls Inc. in Milwaukee. “They are the most desirable tenants, and landlords will make every effort to entice them into a building.”

On the other hand, start-ups may get minimal allowances because landlords fret about the risk of the company folding and breaking the lease. In such cases, “we encourage the CFO to make a presentation to the landlord in the same way he would to investors or Wall Street,” says Arthur G. Greenberg, executive vice president of New York–based Studley Inc., a national real-estate services firm.

Whether to take cash for a build-out or have the landlord finance the build-out depends on several factors. Tenants that get cash contributions must recognize income currently, though the associated expenses will be amortized as leasehold improvements over 15 years. That effectively reduces the value of the cash contribution. On the other hand, tenants that demand the landlord finance the build-out may not be satisfied with the way the job was handled once it is completed. However, the rent is fully deductible. “There are trade-offs here,” says Manley. “No CFO is going to make a decision based on tax considerations alone, but it is a factor that should be part of the big picture when negotiating a lease.”

Changes in Tax Law

As an example, says Manley, a tenant leasing 50,000 square feet of office space in New York may get a build-out allowance as high as $50 per square foot. If the tenant opts to take the allowance as cash, she says, that’s a payment of $2.5 million, which, for those clients with a federal corporate-income-tax rate of 35 percent, means a tax bill of $875,000. Federal taxes could be reduced by negotiating reduced rent or a turnkey build-out of the space.

Experts who represent businesses in lease negotiations advise their clients to take a hard look at all the numbers. “We advise our clients to request two quotes from a prospective landlord: one with the build-out allowance and one without,” says Johnson Controls’s Howell. “Then, we can evaluate the cost of borrowing from the landlord, and consider the offer in light of several factors, including tax considerations and the tenant’s cost of capital.” Landlords, he adds, may not be the most efficient lenders, so he often urges clients to consider different approaches to funding — and thus controlling — the build-out themselves.

To maximize tax savings on a build-out, some are turning to an IRS-approved tax method called cost segregation, which allows them to depreciate certain building components over a shorter period of time. Tax law allows some components such as carpeting, wall coverings, millwork, land improvements, and parking lots to be depreciated over 5, 7, or 15 years. There are 130 categories of property that qualify for depreciation over shorter recovery times. In some instances, 25 percent or more of the value of a build-out can be depreciated more quickly, thus yielding substantial tax savings for a tenant.

Larry Brewster, director of federal tax reduction with O’Connor & Associates in Houston, says more companies are moving to reduce federal taxes by depreciating certain items on a more rapid schedule. “CFOs’ biggest concern is, ‘Will this trigger an audit?'” Brewster says. “The IRS actually views this as the correct way for companies to depreciate the cost of build-out.”

P.B. Gray is a business writer based in suburban Boston.

Not-So-Wide-Open SpacesVacancy rates are shrinking in the top 10 office markets in the U.S.

Q3 2005Vacancy Rate in Selected Markets

% Changefrom Q3 2004

1. Dallas/Ft. Worth

25.8%

2%

2. Atlanta

21.3

2.9

3. Houston

20.3

1.5

4. Chicago

19

1.3

5. Los Angeles

15

2.3

6. San Francisco

14.8

4.5

7. South Florida

13.7

2.6

8. Orange County, CA

11.9

4.9

9. New York

10

0.1

10. Washington, D.C.

7%

0.4%

Source: Studley Office Space Data Report

Building the Cube Farm
Leasing experts who negotiate build-outs for business clients have some tips for those looking to lease office space in 2006.

Flexibility is key. Tenants should ensure that plans for design of their new space will accommodate the company’s growth or necessary cutbacks. Make sure subleasing is an option.

Budget enough time for the design and construction of the new space. Review architects’ and builders’ plans carefully. Make changes early — before nails are pounded into walls. Paying contractors overtime can inflate a budget dramatically.

Review all details of the build-out. Demand pricing for all items — even the light switches. A fancy light switch in every office and conference room can increase the electrical budget by 20 percent.